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The Broader Context

ESG considerations are becoming important to more investors and managers each year. The general consensus seems to be moving towards more comprehensive and multifaceted analyses which take into account diverse issues. The main exception to this trend is carbon emissions (CE); besides contributing as an important issue in the environmental (E) pillar, carbon is increasingly taking the status of a stand-alone consideration on its own right, although it is not formally considered to be one of the three pillars (i.e., E, S and G).

This is partly because CE often has the most dramatic impact on investment performance. As we discuss below, a carbon constraint may result in the largest marginal increase in the short-term active risk, and, if not properly integrated, a significant performance hit. In comparison, one may expect the impact of a tilt towards a higher governance (G) score to be moderately positive, and tilts towards higher social (S) and environmental-ex-carbon scores to be relatively mild.

There is also broadening consensus, after decades of waffling, that addressing global warming is a top priority. In parallel, there’s a realization that it’s more effective to avoid adding to the problem than trying to mitigate it further down the road. A natural and hopeful way to achieve this is for investors to impose, and managers to incorporate, mandates for partially reducing investments in high carbon emitters. Even though this does not directly reduce the size of those companies, it does send a strong economic signal that can amplify over time.

What to Measure

What constitutes “high"? Even though it is, at first glance, tempting to single out companies that generate a lot of carbon emissions in an absolute sense, it is much preferable to normalize by some measure of the company’s economic activity. Typically one focuses on carbon emissions intensity (CEI), which is a company’s total carbon emissions divided by its sales. In that way, an investor who targets a level of equity exposure can still reward companies with lower emissions per unit of economic activity. Moreover, from an implementation viewpoint, CEI is more portfolio-friendly as it’s insensitive to replacing a single company with two smaller ones with the same total financials and emissions.

That said, the best approach for normalization is not yet completely settled. Economic activity can be quantified in a number of ways besides sales (e.g., revenue, book value, capitalization), each with its own advantages and disadvantages when trying to compare in a uniform way across industries and countries.

Data Challenges

Even after deciding on a proper definition, it’s not clear how to get decent data to proceed with the analysis. In addition to the same overall data issues that ESG considerations suffer from in general, carbon comes with its own unique challenges.

For one, it’s not a metric that companies are traditionally expected to report. Data are still quite spotty, and usually unavailable in a timely fashion; companies typically report data only once a year with a considerable delay (typically one to two years). In comparison, the data underlying many other issues feeding into the computation of the three pillar scores are easier to judge based on current news (e.g., litigation, company announcements, etc.) or because companies are legally required to report regularly (e.g., board changes).

Another source of ambiguity about how far to go in adding up contributions: should CE be computed directly or on the basis of responsibility? At the moment, emissions are often considered as simply the sum of direct emissions (e.g., fuel owned by the company burned in its vehicles or facilities) and those indirect emissions due to consumed electricity generated by fossil fuels. However, as investors become more familiar with this issue, it’s likely that they will insist on expanding the list of indirect channels. Should a loan to a carbon producer that is necessary for its survival count towards a bank’s emissions? Should providing technology that is necessary to extract fossil fuels count towards emissions for the technology company, or the logistics provider, or the tool manufacturer? Should the mining of fossil fuels count as emissions, even if these are not released directly to the environment or may be double-counted in indirect emissions due to other companies?

What Does the Data Tell Us?

Putting open questions aside for now, what stands out in a first pass of the data? Region and sector differences drive a large part of the systematic variation across companies, although the details depend on the specific combination of definitions, data source, and data hygiene.

To provide some context, here’s what we observe in a popular data provider covering global stocks:

  • Region differences:
    • Swiss companies have low emissions on average;
    • French companies are low, too;
    • Companies in the rest of Europe tend to have low emissions;
    • Australian companies’ emissions tend to be higher on average;
    • Hong Kong companies have the largest average emissions among developed nations;
    • Emerging market companies have high emissions.
  • Sector differences:
    • Financial sector companies have the lowest emissions on average;
    • Information Technology and Health Care vie for second-lowest place over the long term, with Telecommunications dropping significantly in 2019 with Google (Alphabet), Netflix, TripAdvisor, EA, Pandora and other companies being reclassified from IT to TeleComms;
    • Energy and Materials companies vie for second-highest place;
    • Utilities companies have the highest emissions on average by a substantial margin.

Not too many surprises in the above breakdown. However, it’s worth trying to decompose the different contributions, e.g., account for a simultaneous regional and sectoral contribution. On such a closer look, we find that emissions from companies in emerging markets become closer to average; in other words, their high-emissions status appears to be explained in terms of its dominant (extractive) industries. On the other hand, companies in Hong Kong and Singapore appear to have the highest CEI on average; New Zealand is at the other extreme, with emissions near the lowest among countries.

How Does All This Fit in a Portfolio?

While the investment approach of each manager certainly makes a difference, it appears that effects of implementing a low carbon objective within a strategy depend more on the risk objective of the investor, as opposed to the alpha. This is because the long-term return does not seem to be significantly degraded by a material tilt to low-CEI stocks; it may even be boosted. However, when trying to control active risk relative to a benchmark, it can be challenging to deal with a substantial constraint to largely avoid entire sectors of the economy. The combination of maintaining the same level of alpha and tracking-error increase can degrade the long-term information ratio, unless an appropriate low-carbon-emissions version of the original index is adopted as the performance benchmark.

Things are different in the defensive equity/low volatility space, where strategies target a higher Sharpe ratio, or lower volatility, than the index. Here, a tilt to low-carbon-emissions companies is not as constraining as one might think. For example, an overweight to the utilities sector (which is typically due to an explicit or implicit low-beta tilt) can be often replaced with overweights to other sectors with similar risk-return characteristics (e.g., overweight to Financials in the recent past). This makes low volatility investing a fertile ground for propagation of carbon-constrained strategies in the near future.

Uncomfortable, but Achievable

By now it should be clear that incorporating carbon considerations into equity investing has its challenges, with a number of common data concerns including validity, accuracy, frequency, timeliness, and comprehensiveness. And even if you can agree upon a straightforward way to measure the impact of carbon-related activities and surmount the current state of informational shortcomings, successful implementation can come with its own obstacles that vary relative to investment objectives. That said, we believe a sophisticated asset manager can still send a meaningful economic message to the worst carbon polluters without sacrificing the positive risk-return outcomes that clients demand.

Getting Started With ESG

ESG data limitations are but one of the concerns when appraising ESG approaches. Our primer, "What to Look for on the Road to ESG," is a comprehensive implementation guide on the issues you must consider when adding ESG to your portfolio.


The views presented are for general informational purposes only and are not intended as investment advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation, or sponsorship of any company, security, advisory service, or fund. Nor do they purport to address the financial objectives or specific investment needs of any individual reader, investor, or organization. The views are subject to change at any time based upon market or other conditions, are current as of the date indicated, and may be superseded by subsequent market events or other conditions. The information, analyses, and/or opinions expressed are not intended to provide any specific financial, economic, tax, legal, investment advice, or recommendations for any investor. It should not be relied on as the sole basis for investment decisions. While every attempt is made to ensure that all information is accurate, there is no representation or warranty, express or implied, as to the accuracy and completeness of the statements or any information contained herein. Any liability therefore (including in respect of direct, indirect, or consequential loss or damage) is expressly disclaimed. Past performance is no guarantee of future results. Investing involves risk, including fluctuation in value, the possible loss of principal, and total loss of investment.